One of the most interesting questions that I’m asked all about event-driven income trading opportunities. Specifically, how to correctly utilize news or events as a trigger for income opportunitiestraders see major price gaps and huge increases in volume as a result of earnings surprise, earnings revision, takeover rumors or other types of events that can cause major change in price.
While the underlying reason for the explosive price change can be one of dozens of different reasons, it’s very important to know when to fade these types of announcementsalternatively initiate positions in the direction of the price move.
No one knows for sure which way these strong momentum moves will turn outt’s very important to know how to deal with them whenever they occur.
There are several factors that I take into account when analyzing event driven price swings for the purpose of deciding whether the price breakout or gap will have follow through or looks like a reversal candidate.
These factors or indications are all analyzed together and give me a good indication of the likelihood of seeing follow through or a price reversal ahead by taking into account all relevant factor.
The first and the most fundamental factor is the underlying reason for the sudden change in price.
While I can spend hours going through all the different fundamental factors that can cause price to drastically change, what you need to know is whether the news was expected or not.
If the news was expected, you have to look at the difference between the actual news that was released and compare it to the estimate.
In other words, If a report expected the company to make one dollar per share and the company earns two, it will have a much bigger impact on the price of the underlying asset then if the company expects to make two dollars and the stock earns 2.15 cents.
While in the second example the company made more money in the quarter, the difference between the expectation and the actual released number is much smaller than in the first example, where the company was expected to make 1 dollar but made 2.
So the difference between the expectation and the actual number was a dollar, while in the second example, the difference between the estimate and the actual released number was only 15 cents. Even though the stock earned more, the expected earnings number is only a 15 cents difference. Therefore, the difference between the expectation and the released number is what you need to take into the consideration instead of the actual released number.
On the other hand, the news or the announcement that caused the major change in price was unexpected, then it’s impossible to compare to anything from the past and we have to look at three technical factors, which I will go over one by one.
Is the Asset Moving Ahead of the News?
One factor that we want to look at is whether or not the underlying asset was moving ahead of the news.
This often happens when company insiders who know ahead of time that the company is going to be coming out with an important report and buy or sell ahead of time.
This often happens before take overs and earnings surprises. The typical scenario you will see is a sudden run up in the price of the stock that begins a few days prior to the announcement.
By the time the announcement occurs, the price of the underlying asset already “priced in” the anticipated change in the price of the asset and the typical reaction is a price reversal shortly following the announcement.
Don’t forget, you always have to look at the price data preceding the announcement and see if the asset began moving sharply directionally in anticipation of the news or the trigger for the major price change.
In this example, Google stock ran up close to $75 dollars in the days leading up to earnings release date and only moved higher fractionally after the news was released.
The next technical factor that you have to take into account is the direction of the main trend.
About 85% of the time, the underlying asset will revert to the direction of the main trend, which we can determine by looking at whether the stock is trading above or below the 50 day moving average prior the announcement.
If the stock is trading above the 50 day line and the stock moves higher after the announcement, the odds favor the stock continuing to move in that direction over the next few sessions.
On the other hand, if the stock is trading above the 50 day line and the directional gap or major price move is down or away from the trend, the odds are strong that price will revert back to the main trend within the next few weeks and that means the odds of the price continuing moving lower over time is reduced substantially.
Always check the direction of the main trend, prior to the report or the announcement, because the odds are strong that the asset will revert back to the main trend over the next few weeks, following the announcement.
In the Tesla example that you see on the screen, earnings caused a strong gap against the main trend, but in less than one week, price action reverted back to the main trend, which is lower and typically, trading action reverts back to the main trend, similarly to the example that you see on the screen.
The next technical factor that we want to take into account is the RSI oscillator and what I do is change the traditional 14 day setting to 10 days since we are following short-term price change and the 10 day setting tends to react a bit better to short-term price change, at least according to several years of back testing.
What we want to do is see whether or not the sudden price change causes the RSI to instantly move into deep oversold or overbought price levels. If the price spike instantly puts the asset into deep oversold or overbought territory, we may want to reconsider going in the direction of the price move.
In this example, you can see the TLT ETF move from strong overbought price levels to the upside to deep oversold price levels to.
The typical indication for oversold is 30 and overbought is 70. The RSI is a very sturdy indicator, much sturdier than other oscillators and it’s the only one that I rely on since other like the stochastics can cause false signals very easily, so I tend to stick to the RSI oscillator the great majority of the time.
In summary, initiating credit spreads in the direction of a major price spike or even driven income trading is a viable method of selecting income opportunities, because price gains are quicker, liquidity is stronger and implied volatility is typically going through the roof.
But we have to take into consideration several factors to determine whether or not the underlying asset runs the risk of continuing moving in the direction of the price spike or is a prime candidate for a reversal.
We take into account several factors to help us make this decision, including the actual announcement in relationship to the expectations, assuming the announcement was expected.
If on the other hand the announcement or the news was not expected, we have to take into account technical factors, such the type of price action that occurred prior to the announcement and how much the stock moved up or down ahead of the announcement, the direction of the main trend prior to the announcement.